Schemes react to costly derivatives reform

Schemes now have at least three years to ensure these trades accord with the European market infrastructure regulation (EMIR), which is to require centralised clearing of these trades, especially its requirements on the nature of the collateral held by funds.

As they stand, the incoming clearinghouse model will base collateral requirements on net positions, which will disadvantage funds' long-term strategies. It will also require collateral in cash, whereas most funds hold high quality bonds, so reducing their investment returns.

The extent of the employment of these derivatives – interest rate and inflation swaps, and some longevity hedges – varies, with large players historically being heavy users.

Vanessa James, investment director at the £3.86 billion London Pensions Fund Authority (LPFA), said its investments would be hit, along with a lot of other large funds that have liability-driven investment (LDI) strategies.

She said: “Now transactions are implemented through the counterparties with which our fund has contracts on a one-to-one basis and our collateral is invested in a mixture of fixed interest instruments, some of which match with the spot interest payments.

“And although in theory centralised clearing is an advantage, it would not be to our advantage.”

But not all large funds are affected.

Roger Gray, CIO at the £32 billion Universities Superannuation Scheme (USS), said the plan makes little use of OTC derivatives at the moment, apart from short-dated foreign exchange derivatives, which he believed would be exempted.

He added: “We do envisage greater OTC derivatives use in future but are not unduly concerned about central clearing.”

Rules tightening

The changes are intended to make OTC clearing safer and cheaper.

And while the length of the exemption is uncertain – the European Parliament’s economic and monetary affairs committee having proposed three years and the European Commission five – there is consensus that as it stands the regulation would be detrimental to pension funds that engage in OTC derivative trades.

One problem is that the clearinghouse business model bases collateral requirements on net positions.

James said: “Non-pension funds in the swaps market have offsetting positions, which lowers the collateral they have to pay.

“But we would be permanently long – 20 to 30 years depending on the period of the strategy.

“This means we would have to tie up more money than now in collateral payments, most probably in non-interest bearing instruments.”

This highlights another problem, according to Julian Le Fanu, policy adviser for European regulation at the National Association of Pension Funds (NAPF) – most clearing houses only accept collateral and pension funds don’t hold cash.

He said: “Instead they have lots of very good quality government bonds.”

This has major cost implications for pension funds using an LDI strategy, notedAndrew Giles, co-CIO at Insight Investment, which runs the LPFA’s liability-driven product.

Those holding government bonds, for a 3-4% yield, to cover potential collateral calls would be forced to convert to cash, reducing that yield to a negligible amount.

He said: “And because they are of such long duration they will tend to own quite a lot of collateral, typically of the order of 20-25% of the size of the hedges.

“So giving up a 4% yield on 25% reduces the return by 1% per annum. That’s the equivalent of a 20% immediate impact on solvency.”

Time to lobby

The NAPF, backed up by asset managers such as Insight, have argued for the exemption of pension funds, as part of the non-financial counterparty exemption, which was extended to corporates.

Instead they were granted the temporary exemption from the clearing obligation to allow time to find arrangements more acceptable to pension schemes.

Le Fanu suggested changes to margin requirements; a variation margin that can be seized should a participant be unable to meet its obligations, and an initial margin that serves as a buffer for the clearinghouse.

He said: “While there might not be much movement on the variation margin the initial margin could be based on different criteria to address the fact participants using derivatives as a risk mitigation tool are subsidising those with two-way positions.”

Giles said clearinghouses should be required to either accept high-grade government bonds alongside cash for variation margin or demonstrate conclusively why that can’t be the case.

He said: “People trading in these markets say they would view swaps based on cash or high-grade government bonds in exactly the same way.”

It is clear funds need a conversion mechanism to secure cash, and asset managers are arguing for an expanded clearinghouse role to provide that conversion or repo facility, and counter liquidity risk by giving access to the interbank market and ultimately central banks.

Giles said: We argue the liquidity risk is better gathered together in a central counterparty that can make the necessary investment in people, systems and process with the ultimate recourse of central bank liquidity, than dispersed across thousands of pension funds and life insurance companies scattered across Europe.”